Many procurement organizations “offer” payment terms to suppliers which provide for a discount off the invoice price if the invoice is paid early. For example, with a term of 2% 10 Net 30, the buyer may deduct 2% from the invoice price if they pay by day 10. Essentially, the supplier is paying 2% of the invoice value for accelerating payment by 20 days. That’s an annualized percentage rate (APR) of 36%. When looking at these figures, one might come to accept that these types of rates are the only option, or at least the BEST financing option, but in reality nothing could be further from the truth.
PrimeRevenue has analyzed over $1 trillion in spend and through this extensive research it became very obvious that very few direct material suppliers have financing costs anywhere near those exorbitant rates. Further, investment grade suppliers make up a significant proportion of suppliers on discount terms which clearly would not be the case if suppliers looked at early payment discounts as a way to obtain working capital finance.
So why do suppliers agree to these discount terms? Primarily to win business as this practice enables the supplier to offer a price discount to favored customers without impacting list price. Further, most procurement organizations are incented to obtain discount terms because their compensation is based on price rather than on working capital and cash flow results. PrimeRevenue has worked with clients who had rates as skewed as 2% 60 Net 61 – a 730% APR!
There are some industry members who advocate for a broader application of discount fees in the supply chain as a means of generating income for the buyer. This approach is based on the theory that there is a significant amount of spend with suppliers who will find early payment discounts an attractive form of working capital finance. This premise is for the most part false, at least in the direct material world. Interest rates on terms such as 2% 10 Net 30 or 1% 10 Net 30, or in fact any rate that translates to an APR of 15%+ places a heavy financial burden on suppliers. Such early payment discounts increase costs in the supply chain and represent cost shifting from buyer to supplier rather than a cost reduction across the supply chain. No efficiency is gained by charging suppliers a very high interest rate to get paid early. There is a role for early payment discounts, but it is a niche role like P-Card and that niche isn’t with critical suppliers in the direct material supply chain.